A New, Eclectic View of the Great Depression: Part II- Non-monetary Influences and the “Golden Fetters” Model

23 Jul

concerned shareholders outside Berlin bank during wake of the 1931 banking crisis.

Non-monetary Roles

While Friedman and Schwartz, Bernanke, and Eichengreen all agree that the impulse to the depression was the US monetary tightening in 1928, both Eichengreen  (1992) and Bernanke (1983) stress that, while this was the impetus, the duration cannot be accounted for by a mono-causal theory, and that the financial crises and bank runs during the first half of the 1920s also played contributing roles.

In his 1983 work, Bernanke notes the high correlation between the banking crisis and declines in output,  and argues that the combination bank of bank runs and insolvency of debtors increased the costs of credit intermediation, which affected aggregate demand and had real effects on the economy.  This hypothesis was not meant to supplant that then-reigning monetarist interpretation, but merely to compliment it.  The attractiveness of this particular analysis is that it simultaneously accounts for both the magnitude and duration of the Depression, and that it does not assume irrationality or “animal spirits” on the behalf of economic agents, but instead assumes rationality.

First, Bernanke illustrates the two main causes of the financial collapse- the bank runs and the level of inside debt.  The bank runs of 1930-1932 were initiated by “bad financial news” and grim forecasts.  As banks began liquidating their assets, prices were driven down, causing some banks to fail.  Thus, merely the expectation of bank runs may result in a self-fulfilling prophecy.  The second mechanism is what Bernanke refers to as the “debt crisis,” whereby any deflation exacerbated the burden on banks, because debts were nominal and indexed to changes in the prices level.  Hence the term debt-deflation.  Bernanke notes that the level of inside debt was particularly high for both households and farmers, as the level of mortgage default rose to over 60% in some cities and nearly half of all farmers’ mortgages were delinquent by 1933.  Bernanke notes that although debt crises were not by any means unprecedented in the history of recessions, the magnitude of this one was.

The series of bank runs and the extraordinarily high level of inside debt inevitably led to an increase in the costs of credit intermediation (the flow of funds from lenders to borrowers).  Now, as loans tuned sour, debtors became increasingly insolvent, and as bank capital was squeezed, banks found it harder and harder to value the quality of their loans.  Consequently, to avoid further losses, they vastly curtailed the total amount of outstanding credit.  Indeed, the magnitude of this credit contraction in the US was twice that of any other major economy during the Depression, with farmers, households, and small businessmen being hit the hardest.   Thus, despite there being low yields on treasury or blue-chip corporate liabilities—typical indicators of easy money—it was just an illusion.  Even those who would be deemed creditworthy in good times could not get loans, as capital markets had effectively dried up.  The spread between Baa corporate bonds and T-bills is indicative of taste for safe, liquid assets.  Bernanke notes that from 1929 to 1932, the spread increased 5.5% percentage points, from 2.5% to 8%.  Even two years after the Depression’s nadir—marked as the March 1933 bank holiday—there was till a “genuine unsatisfied demand for credit by solvent borrowers.”  This reflects a change in attitude among bankers, who had, as a result of the crisis, grown “chastened” and “conservative.”

Of additional importance is the correlation between the banking crises and the reduction of outstanding credit.  Bernanke notes that the credit contraction “shared the rhythm of the banking crises.”  Such a reduction in aggregate demand naturally had a deleterious effect on GDP.  The argument is as follows; as the cost of credit intermediation increased, it became more expensive for borrowers to take out loans, which lead to a decline in aggregate consumption of goods.  To quantitatively determine the magnitude of this nonmonetary hypothesis, Bernanke fits two output equations using monetary variables and then adds in nonmonetary proxies, such as deposits of failing banks and liabilities of failing businesses.  What Bernanke finds is that “adding proxies for the financial crisis substantially improves the performance of these equations.”  This indicates that the Friedman and Schwartz monetary interpretation on its own insufficiently accounts for the Depression, failing to explain the magnitude of the output trends from 1930-1933.  Thus, it can be concluded that nonmonetary aspects of the financial crisis played a significant contributing role in the depth and duration of the Depression, and that any complete analysis must account for these variables.

The “Golden Fetters” Model

The question still remains as to why the central banking authorities did not act to stem the financial collapse?  Eichengreen’s answer is that the gold standard as it had come to be tied the hands of the authorities (hence, the title of his book).  Under the gold standard, if one bank were to inflate, lower interest rates would cause outflows of gold, and quickly negate any efforts to relate if parity was to be maintained.  Additionally, the inflating country would face a credibility problem, so foreign nations would ask to have their gold redeemed, and there would be a “flight from foreign exchange,” further counteracting the inflating country’s efforts if the standards was to be maintained.  There was thus a dilemma countries faced; they could either maintain the gold standard, or reflate.  They could only do both if they did so cooperatively, but, as stated in Part I, such cooperation had deteriorated since the war.  Eichengreen notes that in 1993, the London Economic Conference was one such attempt to engage in coordinated efforts to reflate.  However, the conference was “an utter failure,” as war reparation questions were still on the table, and policymakers continued to butt heads.

To illustrate the interplay between maintaining gold, trying to reflate unilaterally, and the non-monetary influences at hand, Eichengreen points to the German Reichsbank experience, which at the onset of the Depression was dangerously close to the mandated cover ratio of 40% due to extensive debt.  During the Austrian banking crisis of 1931, Central European capital markets froze, and the Reichsbank could not redeem their deposits in Vienna.  When the news spread of the deteriorating balance sheets of Central European banks, foreign nations quickly demanded gold redemption, further exacerbating the liquidity problem.  When the Reichsbank decided to act and provide liquidity, its efforts were quickly stymied by further capital outflows induced by the lower interest rates.  Thus, the Reichsbank was forced into passivity by its golden fetters.


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